Vacation and Thorntons Takeover Bid

Back from a week’s holiday during which one of my holdings (Elementis) issued a profit warning while another was the subject of a possible bid (Netcall). Neither prompted me to take action as I was on holiday even though I spotted the news. The Greek crisis is not yet over and one gets the impression the deadlines keep moving out and most knowledgeable commentators expect some last minute fudge to allow Greece to stay in the Eurozone. At least my total portfolio value was up at the end of the week for those who might worry that taking time out over the summer and ignoring the day to day market gyrations for some time will damage their investments.

One interesting item of news was the agreed bid for Thorntons, the chocolate company, by Ferrero at 145p per share. The share price before the announcement was 101p and the offer looks a very fair one.

I have not held Thorntons for a long time but it reminded me to look back at a review I wrote on the company  in 2003 which won a competition run by Investors Chronicle. The share price then was 133p.  It was entitled “A Low Risk Bet on Financial Structure” and it explained why profits might improve substantially simply by paying down the debt and reducing interest payments over the next few years. The business was still very cash generative and had some positive aspects, but had suffered from a patchy trading history and recent over-expansion funded via debt. Here are a couple of paragraphs from the original article:

Even with past poor trading results, the business has always been massively cash generative. In the last two years cash inflow from operations has been over £21m per year, and capital expenditure was reduced to less than £3m last year. Even if trading remains much the same, this business will throw off enormous sums of cash in the next few years.

What will that cash be used for? Will it be wasted on acquisitions, foreign ventures, tarting up the stores, or unprofitable expansion? Well so far it has been primarily used to repay debt. If that process continues then profits after interest payments will rise by 35% for that reason alone over the next few years.”

Investors who acted on my report might have made money because the share price did increase in the next few years as the profits improved, reaching almost 200p in 2007. What happened subsequently?  Revenue certainly increased but profits did not. In a good year they were flat, and in a bad year (typically when another “restructuring” was undertaken) they were zero. They also got through several CEOs in this period. So investors who held on would have been disappointed.

The chocolate market seemed to be changing with consumers moving to the extremes of high quality and strongly branded products (such as those sold by Ferrero) with supermarkets taking the lion’s share of the traditional boxed chocolate market with sales to middle-aged mums. Tinkering with the shop format at Thornton’s and moving into sales via supermarkets and on-line did not seem to help much. And having a low-cost vertically integrated structure did not help either.

So the underlying business problems of the company were never resolved. The moral is that investing simply on the basis of financial numbers such as future cash flows can be a tricky exercise. Retailers that rely on consumer tastes can be vulnerable to market changes just like any business. It will be interesting to see how Ferrero change this business – presumably they see some potential in it that others have not managed to realise of late.

Roger Lawson

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